Gold To Replicate Oils Parabolic Move, 30-Year Treasury Yields To Soar...

With multiple bank failures looming and the US government doing nothing but take on bad debt and assets onto their balance sheet we are looking for new lows in the US dollar as the fundamental backdrop of the US financial system continues to worsen by the day. Inflationary pressures continue to mount with Oil and food hovering near their all-time highs, and the US continues to be hardest hit with respect to inflation due to the high cost of imports based on the declining purchasing power of the dollar. Note that while Europe for example has to pay the same $145 for a barrel of Oil that we do, their currency has also appreciated almost 20% since last year thereby mitigating some of their inflationary pressure. Furthermore, with the US posting its sixth straight month of job losses in June, and the employment picture getting seemingly worse by the day, you can expect the unemployment rate to start ticking up toward 6% by year end. Take into consideration that these looming bank failures will definitely lead to large job losses in financial services in addition to layoffs recently announced within the energy-sensitive transportation sector i.e. airlines and car companies like GM. 

In essence, what is happening is that the US government is taking on very large amounts of debt at the same time that their revenue base (i.e. tax collection) is declining due to higher unemployment and high inflation which curbs consumer spending on discretionary items and hence produces slower growth for US corporations and therefore less corporate tax generation. Think of the US as a large company with debt levels climbing significantly and revenue and profit declining. What usually happens in a situation like this? Well lenders usually begin to become much less willing to lend capital at prevailing rates, and at the same time the debt-laden institution is more likely to want to raise additional capital to maintain sufficient debt to equity ratios (and/or bailout failing financial institutions). The rising debt levels coupled with declining income lead to the perception of a higher probability of default (even if slightly) and the higher probability gets priced into borrowing costs in the form of higher rates needing to be paid to lenders. What will happen is that demand for newly issued treasuries will begin to wane and large current holders of bonds (ie China and Japan) will likely be more inclined to reduce their holdings of US debt as risk levels associated with these bonds rise in conjunction with the fact that the value of these bonds continue to decline due to the devaluation of the dollar.  You can see how a situation like this turns into a rather vicious circle, with weak fundamentals affecting dollar values and dollar values causing a negative change in behavior which in turn puts pressure on fundamentals.  High inflation coupled with slow growth, rising unemployment, a weak currency, and rising debt levels is likely the worst situation an economy can be in which is why monetary policy is seen as so critical in maintaing all-important price stability. When inflation begins to soar, and central banks begin to lose credibility in containing inflation expectations it is very difficult to work an economy back to stable ground without severe consequences. Hence, we are expecting the yield on the 30-Year Treasury Bond to go much higher than the 4.44% it currently sits at as the risk associated with holding US debt increases and the expectation of prolonged high inflation begins to take form. Note that while the Fed has full control over rates at the short end of the yield curve (ie Fed Funds Rate), the Fed has zero control over yields at the long end which are completely set by open market forces.

Now looking at the trades, Gold has several things going for it on a fundamental as well as technical basis. First off, we are in a financial storm predicated on worries over the soundness of financial institutions and the inherent value of the US dollar. This is the perfect backdrop for gold, as global investors tend to run to the yellow metal as the ultimate safe haven in times of uncertainty within the financial system. Secondly, inflation expectations remain high and the dollar continues to weaken.   Thirdly, central bank diversification out of US bonds is likely to benefit gold as central banks tend to increase their gold holdings in times of uncertainty and environments where risk aversion is prevalent.  Fourthly, the recent double bottom at 85 on the GLD chart looks eerily similar to the double bottom at 80 we spotted on the USO chart back in March which ultimately presaged Oils parabolic move from the 80s to 140s. Take a close look at the USO chart below, paying particular attention to the mid March 2008 to early April 2008 double bottom at 80. Now stretch it out over a couple months rather than one month, and notice how closely it resembles the mid April to mid June double bottom at 85 on the GLD chart. They are almost perfect replicas and we believe we are at the same exact stage of the Gold breakout with respect to Oil....just beginning a major move to the upside. Moreover, with Oil nearly doubling over the past year and significant percentage gains made, it is likely that hedge funds and large institutions are now in search of the next asset class which may have greater potential for larger percentage gains down the road. This will likely lead them to Gold, as the asset class is similar and it keeps them highly hedged against inflation.  Hence, with fundamentals as well as technicals in place we believe that Gold has potential to become the new Oil going into year end, and are looking for a very strong double top breakout over 100 in the GLD very soon. In this kind of environment, with inflation expectations running high as well as multiple looming bank failures there really is no limit to how high Gold can go. Would it surprise me to see $1500-2000/oz by year end? No. Based on these assumptions, we have been buying the September 100 GLD calls here and will likely sit on these until Gold breaks out over $1000. Also note that large institutions have been taking extremely large positions in these calls over the past few sessions, with over 60,000 calls being bought yesterday and over 110,000 in open interest. Second of all, we have also been buying the September 90 puts on the TLT which is iShares Lehman 20+ Year Treasury Bond ETF. It essentially tracks bond prices at the long end of the yield curve, and since we are bearish on bonds going forward we'd like to have some exposure to the downside move.

REPOST: Global Darwinian Forces May Produce Major Exogenous Event Blindsiding US Economy...

We wrote this article back on April 5th, and think it is extremely relevant to our current global situation, all comments welcome:


By all economic measures, the United States is clearly in a state of marked weakness. Economic growth is at or near zero, unemployment is rising, the banking system is in critical condition, housing prices continue to decline, the US consumer is up to its ears in debt, the dollar continues to make new lows versus every major currency, inflation shows no signs of abating, and the Fed is running around like a headless chicken literally doing everything it can to prevent the entire system from collapsing. This is not a subjective assessment, it is our grave reality. So what now? Where do we go from here?

Well the obvious answer would be to fix everything that appears to be broken, clean up inefficient systems, attempt to reinvigorate the economy, and ultimately rebuild confidence in the US financial system over time. However, what I fear most is that in this time of distress we may no longer have the luxury of time. I believe it is possible that one of the many emerging superpowers may make a play for global dominance in the near future. Yes, I know this is a bold statement, but let me explain. Over the past several decades the United States has clearly been the world's superpower. It has been the steam engine driving the global economy as continuous wealth creation here has driven demand for foreign goods thereby creating wealth and GDP growth overseas. We are clearly the largest consuming nation in the world, and most of our foreign counterparties have done everything they can to see that growth here continues as incremental gains in US GDP inevitably trickle down to their own economies. However, it appears now that the global economy has approached the point where our significance in the global growth equation has diminished. It appears as if our emerging market counterparties have grown to a level where collectively they are able to maintain global growth without the neccessity of US demand. Where is the evidence of this? The commodities market. We have virtually every major commodity (Gold, Oil, Coal, Grains, Corn) at or near nominal highs, with many now approaching their inflation-adjusted highs. What is most notable however is that these commodities are making this move with the United States literally on the brink of recession! How is this possible? How is it possible that Oil is near $110 per barrel with such weak US demand? How is it possible with the US near recession that global Oil demand is still greater than global Oil supply with Oil being pumped at maximum capacity? It is because of decoupling. The world no longer relies on the US as the primary engine of global growth anymore. This position has been taken over by the likes of China, India, and Brazil. While the US has been toiling with credit crises, a housing slump, and increasing debt loads, the emerging economies have grown into such a dominant state of hypergrowth that their only challenge is to make sure that growth does not get so excessive that it becomes unsustainable, and moreover that inflation remains contained. This dominant position, I'm afraid, may produce some sort of climactic consequence for the United States. Let me explain.

We as mere individuals, will never understand the desire to become a global superpower. This desire is something reserved for continents, nations, and unions as it is impossible for us as mere individuals to achieve such status. However, even though we may not have the capacity to understand this desire, we know that it exists. We know that every single day every sovereign nation is actively working or has the innate desire to become the strongest entity in the world. Why does this happen? What is the driving force behind this phenomenon? Well in my opinion it is driven by the underlying principle that the world lacks enough supply of natural resources to prolong the existence of every single nation over the long run. Over time, as the world begins to approach levels where natural resources are being fiercely competed over because of inadequate supplies and/or unusually high global demand at the margin, the strongest nations will attempt to force weaker nations into further weakness in the hope that this action may curtail overall demand and allow the strongest nations to accumulate necessary supplies at cheaper prices. It is Darwinism at its purest, and it is ultimately driven by the idea that while economic harmony may exist when the strongest parties are satisfied with the distribution of goods and resources, extreme competitive behavior will arise when those parties become dissatisfied with the allocation of resources, especially those resources necessary for independent survival. It is very much akin to the behavior of animals living in a jungle free from the so-called orders of society. When all animals including the strongest are fed and all so-called entities appear satisfied, harmony may exist because there is no need for competition as supplies of resources are adequate enough to meet the demands of all entities. However, if/when the strongest entities become dissatisfied with their levels of consumption, we will likely see an extreme uptick in competitive behavior as the idea of the natural order for satisfaction dictates that the strongest must be first to be completely satisfied. If/when this natural order appears to be imbalanced in that the strongest are not receiving adequate supplies, the strongest entities will likely seek to not only eliminate those entities which they believe will restore natural balance, but they will specifically seek to eliminate those who they believe will be easiest to eliminate (i.e. those entities who appear weakest). Make sense? Ok so what resource are we speaking of specifically when we speak of resources necessary for survival? We are speaking of crude Oil. Every single other commodity is secondary to crude oil in terms of necessity for survival. Gold, corn, wheat, coal, even steel are all secondary commodities. We don't need corn or even grain to survive, and coal and other fossil fuels are simply alternatives to the most important fossil fuel of all, crude oil. Without crude oil, factories would come to a stand still, refineries would be unable to produce gasoline, airplanes would be grounded, heating oil would be unable to be produced, and ultimately unemployment would skyrocket as productive inputs are unable to function and means of transportation become idle. It is the reason why there is literally no limit to how high the price of oil can go over the long run. Its significance as the world's primary energy source produces wars, wreaks havoc within the economic supply chain, and has the capacity to bring entire nations to its knees.

US Economy At Major Turning Point, Intervention Needed Now...

Paulson + Bernanke & Co. have been awfully quiet while we sit here at this critical juncture in the economy and markets, and they really need to step in and do something now if they plan on averting a major economic meltdown. This malaise we currently sit in is at a major pivot point in my opinion. Once Oil breaks above $150 and the DOW breaks down into the 10,000 range it's over, as confidence will have been completely shot and any sort of intervention will have minimal impact. Whether its forex intervention, raising interest rates, and/or raising margin requirements it needs to be done now. Say what you want, but a combination or dollar intervention + raising margin requirements should take some wind out of the sails of Oil and a host of other commodities. Yes I know, Oil is a supply/demand story but breaking the momentum might buy some time for the reality of a global slowdown to set in. Second of all, we are nearing the start of the all important China Olympics which have been an important contributor to demand for energy as China gears up to showcase its country to the entire world. After the culmination of the Olympics or likely before that (as the mkt is forward looking) we should see commodity prices start to come down as the market begins to price in slower economic growth out of China. The rebuilding efforts due to the devastating earthquake in China is sort of a wild card, but the way I see it, it ends up being a zero sum contributor as the increase in government spending to rebuild the country will likely get cancelled out by a decrease in consumer demand due to the necessity of millions of people needing to rebuild their lives first and foremost. Thirdly, the slowdown which appears to be picking up steam overseas in europe is likely a net positive for the US as the relative weakness associated with the dollar and the US economy dissipates a bit as market participants begin to realize that the US is not much worse off than our european counterparts, and may in fact be closer to the end of their malaise than those just beginning to slowdown. We are in such a complex economic environment with Oil + food making all time nominal highs, inflation fears accelerating, slowdowns picking up overseas, the continued perceptions of stress within the banking system, and housing prices continuing to decline that something needs to happen now at least as an effort to quell the momentum to the downside. Traditional, untraditional, it doesn't matter, time is really against us at this point as every day that goes by things seem to get a bit worse. What the puppet masters behind the curtain are doing right now is beyond me, but i have a feeling they're working on something....just doesnt make sense that theyre just waiting for this thing to play out as they know what the end result is if nothing is done.